When it involves money market mutual funds, there are a lot of advantages and disadvantages that investors should be aware of. In the following paragraphs, we will examine the positives and negatives associated with these events.
KEY TAKEAWAYS
Investing in the money market can be highly beneficial, particularly if you are looking for a location to keep cash that is relatively secure but only for a limited period of time.
The returns are often poor, there is a decline in purchasing power, and some investment options in money markets are not covered by the FDIC. These are some of the downsides.
As is the case with any other type of investment, the aforementioned benefits and drawbacks of money market funds can make them an excellent choice in certain circumstances while making them risky in others.
If you’re in your twenties or thirties and have the majority of your savings invested in something like a money market fund, for instance, you’re probably not doing it the right way.
The Benefits And Drawbacks Of Investing In Money Market Funds
A General Explanation of Money Market Funds
Investing in the money market typically results in a return that is only in the single digits.
The risk to principle is often fairly modest when compared to the risk associated with stocks or corporate debt issues. However, prospective investors need to consider a variety of advantages and disadvantages. It’s possible that the lows will much surpass the highs.
Benefits of investing in money market funds
To begin, let’s take a look at the several positive aspects associated with placing the funds in an account with the money market.
Excellent Spot to Keep One’s Funds
When the stock market is particularly turbulent and investors are unsure about where to spend their cash, the money market can be an excellent safe refuge for investors’ money. Why? As was just mentioned, money market wallets and funds are typically seen as having a lower level of risk compared to their counterparts in the stock and bond markets. This is due to the fact that these kinds of funds often put their money into low-risk instruments like certificates of deposit (CDs), short-term commercial paper, and Treasury bills (T-bills). In addition, the return that investors receive from the money market is often in the low single digits, which, even in a declining market, may be considered extremely appealing.
In Most Cases, Liquidity Is Not a Problem.
Money market funds do not typically invest in securities that have a tendency to have a small following or that trade in quantities that are relatively insignificant. Instead, the majority of their trading is done in companies and/or assets that are in relatively high demand (like T-bills, for example). This indicates that they tend to be more liquid, which means that investors can purchase and sell them with relatively little difficulty. Consider this in comparison to, for example, shares of a Chinese micro-cap biotechnology company. There is a possibility that these shares are highly liquid under some circumstances; nonetheless, the audience for the majority of them is probably quite restricted. Because of this, entering and exiting a transaction with such an investment may be challenging if the market were in a downward spiral.
Investing in the money market can, over the course of time, actually cause a person to fall behind in terms of their financial standing since the amount of money they make may not keep up with the increasing costs of living.
The drawbacks of investing in money market funds
Now that we’ve covered the benefits of putting your money in a money market account, let’s speak about the drawbacks.
Potential Loss of Purchasing Power
If an investor’s money market account is yielding a return of 3%, but inflation continues to move along at 4%, the investor is effectively losing the value of their money each year because of the difference between the two rates.
The impact of expenses can be significant.
Even relatively modest annual fees might eat up a sizeable portion of an investor’s return on a money market account when the account is producing returns of 2% or 3%. Because of this, it may become even more challenging for those who invest in the money market to stay up with inflation. The amount of money that fees take away from returns might vary widely from one account or fund to the next. If an individual has $5,000 in an account with a money market that offers 3% yearly and the user is charged $30 in charges, the total return can be significantly influenced. Another example would be if an individual keeps $5,000 in a savings account that yields 2% annually.
$5,000 multiplied by 3% equals a total yield of $150.
Profit of $120 ($150 minus the cost of $30 in fees)
The $30 in fees is equal to 20% of the entire yield, which is a significant deduction that brings the total profit down significantly. The aforementioned sum does not take into account any potential tax obligations that might be incurred in the event that the transaction in question were to take effect outside of an account for retirement.
It’s Possible the FDIC Safety Net Won’t Be There
The FDIC, which stands for the Federal Deposit Insurance Corporation, normally provides depositors with insurance coverage of up to $250,000 per depositor for money funds that are purchased at a bank. On the other hand, money market mutual funds are not typically insured by the government.
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This indicates that although if mutual funds investing in money markets may still be seen as a relatively safe place to put one’s money, there is still a degree of risk which all buyers should be aware of. If an investor were to hold a money market account at a bank in the amount of $20,000 and the bank were to fail, the investor would most likely be made whole immediately through the utilization of this insurance coverage. On the other hand, if the same thing were to happen with a fund, the investor might not be able to get their money back, at least not from the federal government.
Money market mutual funds had an outstanding reputation prior to the financial crisis of 2008, but that reputation was severely damaged by the catastrophe. A widespread panic was caused when a prominent money market fund went below $1.00 per share, breaking the dollar barrier and setting off a rush on the whole money market business. Since that time, the sector has collaborated with the Securities and Exchange Commission, or SEC, to implement stress testing and other steps to boost resilience and restore some of the harm to its reputation.
There Is No Guaranteed Rate Of Return.
Although money market funds often put their money into government securities as well as other vehicles that are regarded as being relatively secure, in order to generate better dividends for their clients, the funds may also be willing to accept some calculated risks. For instance, a fund could make investments in bonds or commercial paper products that involve higher risk in order to try to capture an additional tenth of the fund’s point of return. Given the increased potential for loss, it is important to keep in mind that it is not always the best option to put one’s money into the money market fund that offers the highest yield. It is important to keep in mind that the rate of return that a fund achieved in a prior year is not necessarily indicative of what it may generate in a subsequent year.
It is also essential to note that the alternatives to the money market might not be desired in certain market circumstances. This is something that should be kept in mind. For instance, if you had the dividends or proceeds from the sale of a stock transmitted directly to you (the investor), it’s possible that you wouldn’t be able to achieve the same rate of return. To add insult to injury, reinvesting dividends in stocks during a down market could make return issues much more difficult to solve.
Opportunity that was missed
Even during economic downturns, investors in common stocks have historically seen returns of roughly 8–10% on their investments. An investor might be passing up a chance to earn a higher rate of return by putting their money into a money market index fund, which typically only produces a return of two or three percent of the amount invested. This can have a significant influence on the capacity of an individual to accumulate wealth.
